Competitive Squeezes: When Monopoly is Socially Superior to Free Competition

Nov 9, 2012

Monopolies are commonly considered bad guys in capital markets. They set prices to maximize profit. This means not only that they capture a larger portion of the surplus created, but also that there is a “deadweight loss” to society that results from the lower quantity sold.

However, it is not always true that monopoly is inferior to free competition – under certain conditions, free competition is more socially costly than a monopoly. While monopolists set price to their benefit and to the detriment of society, they are always efficient with respect to their costs. They will minimize their costs for the same output.

Cost-efficiency is not always true for competitors though. In many markets, competitors may be forced to take on costs that would be unnecessary in the absence of competition in order to compete. By trying to capture more of a fixed profit pool, competitors squeeze profits inefficiently, thereby creating a “competitive squeeze”.

Consider the following example:

There is a fishing spot where the total number of fish to be caught each day is fixed by a regulatory quota. Two fishermen use the spot and catch about the same number of fish each day. One day, a salesperson approaches one of them with some expensive bait. It smells nice, and so it attracts more fish. The fisherman buys the expensive bait because it will help him catch more fish in comparison to his competition. The other fisherman sees this, and is forced to buy the expensive bait as well in order to compete. The quality of the bait cancels itself out; each fisherman is left the same as before; and there is a deadweight loss: the social benefits are the same, but the costs are greater. By contrast, a monopolist in this situation would have refused the expensive bait.

(Aside: notice the similarity of this situation with the prisoner’s dilemma)

The key aspect of the fishing example is the existence of the regulatory quota that fixes output, and that fixed output is met. The benefit that the first fisherman received for buying the bait was precisely cancelled out by the negative externality felt by the second fisherman. Similarly, when the second fisherman started using the bait, his benefit was precisely cancelled out by a negative externality borne by the first fisherman.

It’s easy to show (with some math) that at least in some such scenarios, the social loss resulting from free competition is greater than the social loss resulting from a monopoly.

Now that we’ve identified when this happens (fixed output / demand or zero-sum situations), we might think of areas in the real world that this happens. Note that in each of the following situations there is some positive externality / positive effect of the competition. However, it is far from clear that the positive effect is large enough to outweigh the negative competitive squeeze effect described above.

races to patent: only one patent can be granted (fixed outcome), so competitors will invest inefficiently large sums of money to get there first

financial markets: company prospects are fairly independent of stock prices, and they will eventually materialize themselves in the company fundamentals. But since (zero-sum) profits can be made from trading, investors may make inefficiently large investments in analysing companies

legal battles in an adversarial system: the outcome is zero-sum, so litigants may invest inefficiently large amounts on legal counsel

college degrees for job applicants: if we think the demand for jobs is fairly independent of the qualifications of applications (or over-qualifications thereof), then college degrees result in a competitive squeeze for job applicants

advertising: if we think that only so much information can be delivered through advertising, then spending more to create more effective advertisements (e.g. social media advertising) creates a competitive squeeze for advertisers

How does the government cure the competitive squeeze problem?

It could reduce competition or grant a (limited) monopoly, e.g.,

switching to a civil law systems that use a less adversarial approach

granting temporary patents earlier in the R&D process

limiting competition among advertisers

It could restrict costs though regulation, e.g.,

prohibiting the use of expensive bait

limiting the number of college degrees

Of course, each of those actions also has costs, the most obvious one being that the “quality” of outcomes might go down, so it’s not clear how beneficial they would be.